When credit sales are made, the customer owes you money against the sale of goods you made or the services you rendered. A company then has to write off some invoices that are uncollectible at some point in the future.
An invoice or account receivable that can’t be recovered at all even after several attempts is referred to as a bad debt.
A doubtful debt is an invoice that is not a bad debt yet but is expected to be uncollectible at some point in the future.
There are two methods used to record the bad debt expenses of an entity.
- Direct Write-off Method
- Provision / Allowance Method
The first method is generally used for taxation purposes. In this method, we record the bad debt expense at the time when it actually arises. This method is not preferable by the GAAP and other accounting bodies.
There are two methods of dealing with the bad debt expense and the allowance method is one of them. In this method, an estimate is calculated which is reliably measured through the net sales or accounts receivable, forecasting the number of uncollectible invoices.
This estimate is referred to as a provision for doubtful debt. Now, you must be wondering what is meant by the provision. It is defined as a cash outflow of an uncertain amount of time.
Since there is no certain time known of when the bad debt would occur, this bad debt expense would be classified as a provision.
Advantages of allowance method:
In this method, instead of crediting the accounts receivable directly, we increase its contra account i.e. provision for doubtful debt by passing the following entry:
Bad debt expense DR
Provision for doubtful debts CR
The provision for doubtful debt balance is then shown on the balance sheet reducing the accounts receivable.
This way accounts receivable is reduced without having to credit the accounts receivable since specific uncollectible invoices are unknown to us in the present.
Secondly, it portrays the true and fair view of the financial statements. Unlike the direct write-off method, the allowance method allows us to follow the matching principle as well as the conservatism principle.
We report a bad debt expense each year by calculating an estimate as a percentage of net sales or accounts receivable. This way, the expense relates to sales made during the year even though the actual loss occurs at a later time in the future.
The matching principle states that every expense booked shall be matched with the revenue generated that year.
Similarly, the prudence concept or conservatism principle states that any probable expense shall be immediately booked. The allowance method lets us book doubtful debts as bad debt expenses every year.
In the direct write-off, method expense would be reported when the loss has incurred. This results in an understatement of profit. However, under the allowance method, no issues of understatement or overstatement of profits arise.
An accurate reporting of financial statements benefits the investors and management.
Disadvantages of allowance method:
Firstly, this method of bad debt expense requires more work since an estimate shall be calculated at the end of each year in order to bring down the accounts receivable to its net realizable value.
Secondly, an extra ledger of provision for doubtful debt is maintained which could be avoided in the direct write-off method. Thirdly, there are more chances of calculation errors.
Since the amount of provision should be reliably measured in order to be recognized, any miscalculation by a large margin might lead to underestimated or overestimated profit or loss for the year.